The basic option strategies involve buying or selling one call or put. When you are new to options trading, then you can start trading with these. These have simple pay-off profiles, which are easy to calculate. This makes it easier to create plain vanilla strategies, which are easy to understand and create.

However, as you become a more savvy options trader, you can go much beyond these plain vanilla strategies. You can experiment with exciting combinations of call and put options to create complex strategies like bullish and bearish spreads. Creation of these spreads can increase your profits and also limit the probability of losses.

Once you have gained proficiency in trading in options we strongly encourage you to take a look at the spread strategy to increase the range of strategies with which you can trade. These involve buying one option and selling another one either to reduce the cost of trading or the risk involved. So most of the spread strategies involve trading in two options.

Option Ratio Spreads

An extension of the bullish and bearish spreads are the options Ratio Spreads. Here instead of two options, we trade with 3 or more options. From a risk-return perspective, the Option Ratio Spreads are more aggressive than the normal spread strategies.

Options spread strategies can be created for both bullish as well as bearish views. Let us take a look at both of these to understand how you can create these strategies.

Call Ratio Spread

Call Ratio spread is created when the trader is mildly to moderately bullish on the market or the stock. It is created by:

l  Buying a lower strike price call

l  Selling two or more higher strike price calls

If the trader expects a range bound movement in the market, this will be the best profile to help him earn good profits when his view is right.

However, this strategy is more aggressive than the regular spread trading. This is because if the view of the trader is proved to be wrong and the market makes a sharp move either upward or downward then the trader will start incurring losses. In fact, there can be unlimited losses if the market moves upward.

Maximum profit:

The maximum profit can be calculated as:

• Max profit = strike price of short call – strike price of long call + net premium received
• Max profit achieved when the price of underlying = strike price of short calls

Maximum loss:

• Maximum loss = unlimited
• Loss = price of underlying – strike price of short calls – max profit

Break-even points:

• Upper breakeven point = strike price of short calls + (points of maximum profit/number of uncovered calls)
• Lower breakeven point = strike price of long call +/- net premium paid or received

Example:

So now let us take an example to understand how this works:

Suppose we buy an 8400 Nifty call option by paying Rs. 160 as premium and sell two 8600 calls at Rs. 70 premium.

So let us now discuss this strategy in detail.

The net premium that he has paid to create this strategy is (160 -70-70) = 20.

The maximum profit and loss for this profile will be:

l  Max profit = (strike price of short call – strike price of long call + net premium received) = (8600-8400-20) = 180

l  Max loss: Unlimited

There will be two break-even points for this strategy.

l  Upper break-even point = strike price of short calls + (points of maximum profit/number of uncovered calls)

Here we are trading with a ratio of 1:2, hence there is only 1 uncovered call

Therefore, upper break-even point = 8600 + (180/1) = 8780

So we will have unlimited losses when the underlying, i.e. Nifty moves beyond 8780

l  Lower break-even point = (strike price of long call +/- net premium paid or received)

= (8400+20) = 8420

So when the markets fall below 8420, none of the 3 calls will be in-the-money and will expire worthlessly. So there will be a constant loss of Rs. 20 (i.e. the net premium paid) when markets fall below 8420.

The payoff profile of this strategy will be:

We have shown the payoffs of each leg separately to make it easy for you to understand.

The 8400 call which will bring unlimited profits when the markets move beyond (strike price + premium, i.e. 8400+160) 8560. It will become worthless 8400.

The calls which have been sold at 8600 will remain profitable for you as long as markets do not go beyond 8670. Beyond that, they will build unlimited losses.

From the combined profit and loss profile you can see that the calculations that we made earlier are holding true. The maximum profit of Rs. 180 will come when the markets are at 8600 levels.

Many traders across the world are making handsome profits by using Call Ratio Spread. If you feel that the market will remain range-bound and you are willing to take the additional risk then you can try this strategy to profit from the market. When done in the right way this can help you to consistently make money from options when the markets are range bound.